CHAPTER - 1

INTRODUCTION

1.1 Introduction

1.2 Importance of FDI

1.3 Need for Financial Reforms in India

1.4 Banking Reforms in India

1.5 Role of FDI in Banking and Reforms in FDI Policy

1.6 Need for the study

1.7 Objectives of Study

1.8 Hypothesis

1.9 Research Methodology

1.10 Scope and Limitation of the Study

1.11 Chapter Scheme

1.12 Chapter Summary and Conclusion

1
1.1 Introduction

Indian banking has undergone a sea change after liberalization and reforms.

Liberalization and reforms paved the way to foreign direct investment into Indian Banking

Sector. It is more than a decade now that have we have received Foreign Direct Investment

(FDI) in Banking and hence it is important to see the impact on the Indian Banking. The present

study is dedicated to analyze and evaluate the performance of Indian FDI and Non-FDI banks in

the post liberalization era.

FDI is considered as important source of financing the growth of LDCs. It was advised

by policy makers in India to throw wide open the doors to FDI which is supposed to bring ‘huge

advantages with little or no downside”. 1

FDI flows significantly influences the growth of GDP and its impact is relatively higher

in India. FDI has promoted exports and there are no significant inter-country differences in

propensity of FDI to export and import increase with FDI but less than proportionately for which

there are no inter-country differences.2

FDI is considered to be important contributor to the performance of firms. Also that the

performance of FDI is companies are better than that of non-FDI companies and however FDI

companies’ contribution to exports is not great and their import propensity is quite high. 3

It was discussed and now allowed to deregulate FDI restrictions further, e.g. by allowing

FDI in retail trade etc. Policymakers in India as well as external observers attach high

expectations to FDI. “FDI worked wonders in China and can do so in India” (Indian Express,

November 11, 2005).4

The Deputy Secretary if OECD reckoned at the OECD India Investment Roundtable in

2004 that the improved investment climate has not only resulted in more FDI inflows but also in

2
higher GDP growth (OECD India Investment Roundtable 2004). The implicit assumption seems

to be that higher FDI has caused higher growth. 5

1.2 Importance of FDI

It is well accepted fact that external inflows like FDI can supplement domestic savings at

least in the short run (Meier,1995, Moran, 1998). There are divergent views on the long run

impact of FDI on domestic savings and findings of empirical studies are not uniform. However,

FDI can play important role in improving the capacity of the host country to respond to the

emerging opportunities.6

The benefits of FDI can occur to domestic labour in the form of higher wages, to

consumer by way of higher output and lower prices, to government through higher tax revenue,

and most importantly of external economies. For a developing, FDI is significant for

employment generation and improving its productivity as well. Hence, the international flow of

capital is considered as an alternative to labour migration from the poor countries.7 FDI brings to

the recipient country not only foreign capital but also efficient management, superior technology

and innovation in products and marketing technique, which are generally in short supply in the

developing countries. Thus, access to foreign capital helps overcome the managerial and

technological gaps in the host country. Further, foreign firms can increase competition in

domestic markets, reduce monopoly profits and improve quality of products and servies.8

However, there are costs associated with foreign investment, which the host country has

to bear such as special concessions to be offered, likely adverse effects on domestic savings,

deterioration in the terms of trade, balance of payments problems on account of outward

remittances etc. Some of empirical studies on FDI examined the “dependency hypothesis” and

found that FDI discourages savings and investment and pulls down economic growth.9 In fact,

3
the restrictive economic policies followed by the countries have reduced the benefits and

increased the costs of FDI because of costs of regulations, economic costs of production,

inefficient project structures, encouragement of the use of transfer pricing to repatriate profits

and fiscal losses from tax incentives.10,11,12

Traditionally, the FDI has moved from developed to other developed or developing

countries preferably in sectors like mining, tea, coffee, rubber, cocoa plantation, oil extraction

and refining, manufacturing for home production and exports, etc. Gradually their operations

have also included services such as banking, insurance, shipping, hotels, etc. As regards location

choice, the Multi National Enterprises (MNEs) tend to set up their plants in big cities in the

developing countries, where infrastructure facilities are easily available. Therefore, in order to

attract FDI flows, the recipients countries/regions were required to provide basic facilities like

land, power and other public utilities, concessions in the form of tax holiday, development

rebate, rebate on undistributed profits, additional depreciation allowance and subsidized inputs,

etc. 13

The strategies and location choice of MNEs had undergone significant changes between

the 1970s and the 1990s. Some major developments in the world economy identified which have

been instrumental in changing location decision of MNEs during this period. The first major

development is the growth of intellectual capital that was reflected in higher expenditure on

information technology, increase in the knowledge component of the manufacturing goods and

increase in the share of skilled workers in the labour force. The growing significance of these

non-material knowledge-intensive assets was led by tremendous growth of the services sector,

particularly knowledge and information oriented services. Secondly, the location of creation and

use of these knowledge intensive assets have been increasingly influenced by the presence of

4
immobile clusters of complementary value-added activities. Spatial bunching of firms engaged in

related activities have benefited from the presence of one another and of having access to

localized support facilities, shared service centers, distribution networks, customized demand

patterns and specialized factor inputs. This has given rise to “alliance capitalism”, in which the

main shareholders in the wealth sharing process need to collaborate more actively and

purposefully with each other. Third, there is increasing evidence that except for some labour or

resource oriented investment in developing countries; MNEs are increasingly seeking locations,

which offer the best economic and institutional facilities for core competence to be efficiently

utilized. Fourth, the renaissance of market economy and the consequent changes in the

macroeconomic policies and macro-organizational strategies of many national governments have

also contributed significantly to the economic and political risk assessment of FDI by MNEs.14

The “agglomeration” factor has emerged as one of the most important determinants of

regional distribution of FDI flows within a country during the last two decades. Agglomeration

economies emerge when there are some positive externalities in collocating near other economic

units due to the presence of knowledge spillovers, specialized labor markets and supplier

network (Krugman, 1991).15 Statistical results from several studies focusing on developing

economies strongly support the argument that foreign investors are inclined to favour such

locations that could minimize information costs and offer a variety of agglomeration economies.

A common finding in recent studies is that regions with a relatively higher existing stock of

foreign investment are more likely to attract further investments, which confirms the importance

of positive agglomeration externalities.16

Therefore, it emerges that while globalization suggests that the location and ownership of

production should become geographically more dispersed, other economic forces are working

5
towards a more pronounced geographical concentration of such activity both within particular

regions and countries. In the above theoretical backdrop, a survey of the empirical literature has

been carried out highlighting select country experiences and the experiences in the Indian

context.

Table 1.1 depicts host countries determinants of FDI shown as below.

---------------------------------------------------------------------------------------------------------------------------------
Table No: 1.1 Host Country Determinates of FDI
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I. POLICY FRAMEWORK
i) Economic, political and social stability
ii) Rules regarding entry and operations
iii) Standards of treatment of foreign affiliates
iv) Policies on functioning and structure of markets
v) Policies governing mergers and acquisitions
vi) International agreement on FDI
vii) Privatization policy
viii) Trade policy
ix) Tax policy
II. ECONOMIC DETERMINANTS
-------------------------------------------------------------------------------------------------
Types of FDI Principal Economic Determinates
-------------------------------------------------------------------------------------------------
1. Market-seeking 1. Market size and per capita income
2. Market Growth
3. Access to regional and global markets
4. Country-specific consumer preferences
5. Structure of markets

2. Recourses/Asset-seeking 1. Raw materials

2. Low cost unskilled labour
3. Technological, innovative and other assets
4. Physical infrastructure

3. Efficiency seeking 1. Cost of resources and assets, adjusted for labour productivity.
2. Other input cost, transport, telecommunication
3. Membership of a regional agreement conducive to the
establishment of regional corporate networks
--------------------------------------------------------------------------------------------------------------------------------------
III. BUSINESS FACILITATION
1. Investment promotion (image building, investment facilitation services)
2. Investment incentives
3. Hassle costs (related to corruption and administrative efficiency)
4. Social amenities
5. After-investment services
----------------------------------------------------------------------------------------------------------------------------------------
Source: UNCTAD, World Investment Report, 1998: Trends and Determinate

A growing literature has recognized the theoretical possibility of two-way feedbacks

between FDI and economic growth along with their long run and short-run analysis. Empirical

6
infestations in the context of Indian economy, have failed to provide any conclusive evidence in

support of such two-way feedback effects; causality between FDI and economic growth is either

found neutral for India, or to run mainly from economic growth to FDI. They found evidence of

bi-directional causal link, causality running from FDI stock to output is relatively weaker when

considering the entire panel of 15 industries under their study. They do not find strong growth

impact in India’s services sector, even though it was exactly this sector that attracted the bulk of

additional FDI in post-reform era. This is because, while, FDI in services sector appears to be

concentrated in Information and Communication services, the contribution of these services to

total output in the services sector is limited. Hence even if FDI resulted in higher growth in some

IT related services, the impact on total output in the services sector probably remained

insignificant. They argue that euphoria about FDI in India rests on weak empirical foundations.

FDI is unlikely to work wonders if only remaining regulations were relaxed and still more

industries opened up to FDI. They suggest that this is where policy makers may contribute to

maximizing the benefits of FDI in India. Their contribution has less to do with specific FDI

policies. Rather the policy challenge is to improve financial sector development seem to be

important in this regard.17

Following the liberalization of the foreign direct investment policy in India in the early

1990s, FDI to India has increased significantly in the last decade. In view of this, the various

studies are examined which analyze the major determinants affecting regional distribution of FDI

flows in India. The analysis reveals that market size, agglomeration effects and size of

manufacturing and services base in a state, have significant positive impact on FDI flows. The

impact of taxation and cost of labour is negative. While the impact of quality of labour is

ambiguous, infrastructure, however, has significant positive influence on FDI flows. With the

7
presence of a strong agglomeration effect, it is essential to have a conscious and coordinated

effort at the national and the state government level to make the laggard states more attractive to

FDI flows. The efforts may include special thrust on the manufacturing, services and the

infrastructure sectors, or direct policy efforts like in the case of China or a combination of both.16

FDI and India

The 1991 reforms brought changes in three broad areas, collectively known as

liberalization, privatization and globalization. Liberalization did away with regulatory hurdles

and minimized licensing requirements. Privatization reduced the role of the state and public

sector in business. Globalization made it easier for the MNCs to operate in India. India's direct

investment abroad was initiated in 1992. Streamlining of the procedures and substantial

liberalization has been done since 1995. As of now, Indian corporate is allowed to invest abroad

up to 100% of their net worth and is permitted to make overseas investments in business activity.

The following Table No. 1.2 gives major features of four phases of Indian FDI policy,

which is depicting liberalization of FDI policies, phase wise in India over a period of time.

Today, India is the fourth-largest economy in the world and one of the most sought for

destination for FDI. This has led to India’s services sector boom. India has strength in

information technology and other significant areas such as auto components, chemicals, apparels,

pharmaceuticals and jewellery. India has always held promise for global investors, but its rigid

FDI policies were a significant hindrance in this regard. However, as a result of a series of

ambitious and positive economic reforms aimed at deregulating the economy and stimulating

foreign investment, India has positioned itself as one of the front-runners of the rapidly growing

Asia Pacific Region. India has a large pool of skilled managerial and technical expertise. The

8
size of the middle-class population at 300 million exceeds the population of both the US and the

EU, and represents a powerful consumer market.18

Table No: 1.2 - Major features of Indian FDI policies during the four phases
Phase I Phase II Phase III Phase IV
1950-67 1968-80 1980-90 1991 Onwards
Receptive Attitude or Cautious
Restrictive Attitude Gradual Liberalization Open Door Policy.
welcome.

Liberal policies relating to

Non-discriminatory Treatment
to FDI
Higher foreign equity in
Restriction on FDI without technology collaboration,
export-oriented
technology foreignTrade and foreign
unitsallowed.
exchange.

Procedure for
Encouraging FDI in core and
Above 40% stake not allowed remittance of royalty
infrastructure industries
No restrictions on and And technical fees
dividends.Remittance of profits

Allowed only in priority area Liberalized FERA replaced with FEMA

Procedures transparent
Ownership and Control with
FDI controlled by FERA Liberal approach for NRI
Indians
investments

Fast channel for FDI FDI need not be

clearance. accompanied by technology
Discriminating Power in
sanctioning The projects FDI through M&AFDI in
services & Financial Sector-
banks,NBFCs, Insurance

Source: Jeromi P.D. (2002)

Foreign direct investment (FDI) is considered to be the lifeblood for economic

development as far as the developing nations are concerned. FDI to developing countries in the

1990s was the leading source of external financing and has become a key component of national

development strategies for almost all the countries in the world. FDI is considered to be an

essential tool for jump-starting economic growth through its bolstering of domestic capital,

productivity and employment. The reliance on FDI is rising heavily due to its all round

contributions to the economy. The important effect of FDI is its contributions to the growth of

9
the economy. FDI has an impact on country's trade balance, increasing labour standards and

skills, transfer of new technology and innovative ideas, improving infrastructure, skills and the

general business climate.19

Among the various forms of foreign capital inflows to the country (public borrowing,

portfolio investment, bank deposits etc), FDI is generally considered as beneficial to India as it is

motivated largely by the investor’s long term prospects for making profits in production

activities than they directly control. In contrast, portfolio investment and foreign bank lending

are often motivated by short-term profit considerations that can be influence by a variety of

factors. Further they are prone to herd behavior.20 As FDI is non-debt creating as also not prone
21
to quick reversal; it is considered as the most desirable way of getting the external inflows.

Compared to other forms of foreign capital, its significance also lies in the fact that it brings

along modern technology and management techniques. In this context, the Economic Survey

2001-02 underscored the significance of FDI for domestic industry and consumers as it provides

opportunities for technological up gradation, access to global managerial skills and practices,

optional utilization of human and natural resources, help Indian industry to become

internationally competitive, opens up export markets, provides backward and forward linkages.22

India's liberalized FDI policy (2005) allows up to a 100% FDI stake in ventures.

Industrial policy reforms have substantially reduced industrial licensing requirements, removed

restrictions on expansion and facilitated easy access to foreign technology and foreign direct

investment FDI. The real-estate sector is showing upward moving growth curve as a result of a

booming economy and liberalized FDI regime. In March 2005, the government amended the

rules to allow 100 per cent FDI in the construction business. This automatic route has been

permitted in townships, housing, built-up infrastructure and construction development projects

10
including housing, commercial premises, hotels, resorts, hospitals, educational institutions,

recreational facilities, and city-and regional-level infrastructure.23

FDI in banking is raised to 74% from the earlier limits of 49% to further liberalize the

FDI norms in the Banking Sector. The revision in FDI limit will create an enabling environment

for higher FDI inflows along with infusion of new technology and management practices

resulting in enhanced competitiveness. However a FDI inflow in Banking in developing

countries in recent years is drawing attention of the researchers due to its performance in the post

FDI regime.

After the liberalization and reforms in the financial sector in 1991, FDI in banking was

introduced and initially FDI in Banking was allowed up to 49 per cent. Subsequently, FDI policy

in India was liberalized in 2005 and FDI limit was raised from 49 percent to 74 percent.

1.3 Need for Financial reforms in India

Until 1991, India witnessed financial repression in the closed economy. There was

existence of administered interest rates, large preemption of resources by the authorities and

existence of micro regulations directing the major portion of flow of funds to and from financial

intermediaries. During financial repression, private business, not only find themselves with

limited access to credit, but also with less capability of self financing, because high inflation

makes accumulating enough savings to maintain stable real value more difficult. Under those

conditions, private investment decreases and when the cost of credit decreases too much, the

quality of investment often deteriorates. The characteristics described as credit market

segmentation, disintermediation in the regulated segment, scarcity of savings and investment,

and low capital productivity- identify financially repressed economies. This shows that if

financial repression exists, it furnishes negative long-term effect. 24

11
 To overcome all these problems and to stand up the international standards in financial

development, India opted for economic reforms in which financial reform was the major

component of reforms. The main aim of reform was to create efficient productive and

competitive financial industry. Degree of financial repression was reduced while implementing

the reforms. The reforms were introduced to operate financial sector with operational autonomy

with strengthening its financial health. They are classified as first or early phase of generation of

reforms and then second phase of reforms or second-generation reforms. 25

In the first generation of reforms, the internal improvement of financial health of

domestic intermediaries was focused at. In the second phase, the domestic entities were prepared

to face international winds of financial liberalization. Economic reforms in India were also

initiated following an external sector crisis, unlike many other emerging market economies,

where economic reforms were driven by crisis followed by a boom-bust pattern of policy

liberalization. In India, reforms followed a consensus driven pattern of sequenced liberalization

across the sectors. Hence, the reforms are slow but continuous and well targeted.

The financial sector reforms seem to achieve

• Improvement in the financial health

• Improvement in the competitive capabilities

• Improvement in financial infrastructure relating to supervision, audit, technology and

legal framework

• Improvement of level of management competence and

• Suitable modifications in the policy framework etc. 26

1.4 Banking Reforms in India

12
 From time to time, machinery requires servicing or repairing to work efficiently,

similarly banking system required some dose of improvement to comply with the required

standards. Hence, banking sector reforms were introduced to remove the deficiencies in banking

sector. Until 1991 reforms, banking sector was facing problems such as:

• High regulation by the RBI

• Eroded productivity and efficiency of public sector banks

• Continuous losses born by public sector banks

• Increasing NPAs

• Deteriorated portfolio quality

• Poor customer service

• Obsolete work technology

• Unable to meet competitive environment 27

Hence the need of the hour was to introduce some policies to remove all the said

deficiencies. In the light of the above distortions, the Narasimham Committee was appointed in

1991 and it submitted its report within three months in November 1991, with detailed measures

to improve the adverse situation of the banking industry. The main motive of the reforms was to

improve the operational efficiency of the banks to further enhance their productivity and

profitability. 28

In banking sector reforms, a strong attempt was made to improve the financial health of

the banking system, to meet the rising challenges. The reforms were made to bring Indian banks

up to the international standards by accepting prudential regulation and supervisory norms.

Active steps were taken to change Institutional arrangements including the legal framework and

technological system within which the financial institutions and markets operate. Keeping in

13
view the crucial role of effective supervision in the creation of an efficient and stable banking

system the supervisory system is restored. The large banks were attempted to recapitalize

through equity issue even in banking. 29

Some of the first phase reforms include- reduction in Statutory Liquidity Ratio (SLR)&

Cash Reserve Ratio (CRR), deregulation of interest rates, transparent guidelines or norms for

entry and exit of private sector banks, public sector banks allowed direct access to capital

markets, branch licensing policy liberalized, setting up of Debt Recovery Tribunals, Asset

classifications and provisioning, Income recognition, Asset Reconstruction Fund (ARF), priority
30
sectoral location of total advances fixed at least 40% .

The first phase of banking sector reforms, termed as ‘Curative’ measures, came up with

its main objectives to improve the operational efficiency of banks. Although the first phase of

banking reforms has seen improvement in the performance of the banks but competition has also

increased with more liberalization, privatization and globalization. With better use of technology,

the new entrants have been able to spur competition, and the public sector banks have suffered,

as they are not using the technology to large extent rather than to an affordable extent, mainly

due to opposition from trade union and high initial costs of installation. 31

In spite of the optimistic views about the growth of banking industry in terms of branch

expansion, deposit mobilization etc. several distortions have still crept into the system which are

as follows-increasing competition, increasing NPAs, Obsolete technology, etc. Hence

Government of India appointed second Narasimham Committee under the chairmanship of Mr.

M. Narasimham in 1998 to review the first phase of banking reforms and chart out a program for

further reforms, necessary to strengthen India’s financial system so as to make it internationally

competitive. This situation has arisen mainly due to the global changes occurring in the world

14
economy, which has made each industry very competitive. In the second phase of the reforms in

banking the diversification of the banking business was promoted. The capital adequacy norms

have improved the capitalization of the banks. Statutory Liquidity Ratio has been brought down

to 25 from 38%. Transparency with disclosure norms is brought in the balance sheet of the

banks. Legislative provisions, technology development, market infrastructure such as settlement

systems, trading systems, and the like have all to be developed. The committee reviewed the

performance of the banks in light of first phase of reforms and submitted its report with some

repaired and some new recommendations. There were no new recommendations except- merger

of strong units of banks and adaptation of the ‘narrow banking’ concept to rehabilitate weaker

banks. 32

The second banking sector reform is going on since 1999; it has shown improvement in

the performance of banks and on the other side, many changes have occurred due to the entry of

banks in the global market. The banking sector reforms aimed to enhancing productivity,

profitability, efficiency and competitiveness of the banking industry. Since more than a decade

of banking reforms have been completed, it is essential to review the various issues of banking

sector reforms, especially its post reform impact on NPAs, interest income, non-interest income,

capital adequacy, priority sector advances and SLR and CRR, etc. 33

1.5 Role of FDI in Banking and Reforms in FDI Policy

• FDI Policy in India

Total FDI allowed in Banking was 49% in the since 2001.

1. Limit for FDI under automatic route in private sector banks

a) In terms of the Press Note No.4 (2001 Series) dated May 21, 2001 issued by Ministry of

Commerce & Industry, Government of India, FDI up to 49 per cent from all sources will be

15
permitted in private sector banks under the automatic route, subject to conformity with the

guidelines issued by RBI from time to time.

b) For the purpose of determining the above-mentioned ceiling of 49 per cent FDI under the

“automatic route” in respect of private sector banks, the following category of shares will be

included:

(i) IPOs,

(ii) Private Placements,

(iii) ADRs/ GDRs, and

(iv) Acquisition of shares from existing shareholders

2. Limit for FDI in public sector banks

FDI and Portfolio Investment in nationalized banks are subject to overall statutory limits of

20 per cent as provided under Section 3 (2D) of the Banking Companies (Acquisition & Transfer

of Undertakings) Acts, 1970/80. The same ceiling would also apply in respect of such

investments in State Bank of India and its associate banks.

3. Voting rights of foreign investors

In terms of the statutory provisions under the various banking acts, the voting rights, when

exercised, have been stipulated which are indicated as under:

Private Sector Banks – [Section 12(2) of Banking Regulation Act, 1949]

No person holding shares, in respect of any share held by him, shall exercise voting rights on

poll in excess of ten percent of the total voting rights of all the shareholders.

Nationalized Banks – [Section 3(2E) of Banking Companies (Acquisition and Transfer of

Undertakings) Acts, 1970/80] No shareholder, other than the Central Government, shall be

16
entitled to exercise voting rights in respect of any shares held by him in excess of one percent of

the total voting rights of all the shareholders of the nationalized bank.

State Bank of India (SBI) - (Section 11 of State Bank of India Act,1955) No shareholder, other

than RBI, shall be entitled to exercise voting rights in excess of ten percent of the issued capital,

(Government, in consultation with RBI can raise the above voting right to more than ten

percent).

SBI Associates - [Section 19(1) and (2) of SBI (Subsidiary Bank) Act, 1959] No person shall be

registered as a shareholder in respect of any shares held by him in excess of two hundred shares.

No shareholder, other than SBI, shall be entitled to exercise voting rights in excess of one

percent of the issued capital of the subsidiary bank concerned. 34

The following Table 1.3 shows the liberalized FDI norms for different sectors in India as

following. Maximum FDI Cap in banking is 74%.

Private Sector Banking

The FDI Cap is Administrative -74 per cent from all sources on the automatic route

subject to guidelines issued from RBI from time to time.

Public Sector Banks-The FDI Cap is Statutory - 20 per cent from all sources Inclusive.

The Current limit is 20 per cent inclusive of FDI. The Proposed limit is 40 per cent inclusive of

FDI.

Private Sector Banking- The FDI Cap is Administrative. Total investment allowed is 74

per cent from all sources on the automatic route. It is proposed to make 100% FDI in banking in

near future for the existing banks in private sector. Also it is to be noted that RBI is about to

issue 12 new license to new private sector banks but with FDI limit of 74%.

17
 Table No:1.3- Liberalizations of FDI norms
Sectors FDI
Manufacturing, drugs& Pharmaceuticals ISP not providing gateways , Hotels & Tourism Courier Services 100%
Up to 100% with FDI beyond 74%
Airports
requiring Govt. Approval
Infrastructure relating to marketing of petroleum products 100%
Infrastructure relating to marketing of petroleum products 100%
Pipeline sector 100%
Exploration or Mining of Coal or Lignite for captive consumption 74%
Roads, Highways, ports and harbours 100%
Explorations and Mining of Diamonds and Precious Stones 74%
Projects related to Electricity generation, transmission and distribution 100%
Banking 74%
Telecom Sector 74%
Civil Aviation 49%
Insurance 26%
Source: GOI, FDI Policy 2005

Indian Banking after the advent of FDI

The FDI inflows in Banking industry in developing countries is drawing attention of the

researchers in recent years due to its performance in the post FDI regime. FDI in banking is

raised to 74% from the earlier limits of 49% to further liberalize the FDI norms in the Banking

Sector. “The revision in FDI limit will create an enabling environment for higher FDI inflows

along with infusion of new technology and management practices resulting in enhanced

competitiveness”, (Finance Minister on the changes in Banking Policy, Dec 2004) 35

Banking Industry has revolutionized the transaction and financial services system

worldwide. Through the development in technology, banking services have been availed to the

customers at all times, even after the normal banking hours, on a 24x7 basis. Banking Industry

services is nothing but the access of most of the banking related services, such as verification of

account details, going with the transactions, etc. In today’s world, progress of online services is

18
available to all customers of the concerned bank and can be accessed at any point of time and

from anywhere provided the place is equipped with the Internet facility. Now days, almost all the

banks all over the world, especially the multinational ones, provide their customers with Online

Banking facility. Banking 365 is a call center that deals with personal banking customers.

It basically helps in the marketing of product and services offered by the Bank. Banking 365

provides the following services:

• Banking at the customer's convenience: business banking can be used with the help of the

banking 365 suiting the customers' needs.

• Telephone Banking: With the help of the phone banking system, the customers can have

easy access to his account. In case any problem should arise, there are advisors available at the

other end of the call.

• E-banking: Real time accounts can be accessed over the Internet with the help of the

Banking 365 services. Accounts can be accessed from any part of the world. The online services

provided by the banking 365 also help in paying bills. An account holder can transfer the funds

from one account to the account of the third party. The account holder can perform check

searches, check the standing orders, and make credit card balance and standard enquiry. There

are other products that the bank account holder can avail of and they are Personal Loans, motor

loans, credit cards, mortgages and more. 36

With the ongoing reforms in the Indian financial sector and the many new developments

taking place in the global financial markets, the Indian banking industry has a point to prove in

serving different segments of customers. 37

Till 1990 Mass Banking was a catch phrase in the Indian banking industry. As the PSU

banks had to follow social objectives given by the government hence they segregated their

19
operations into Development Banking, Investment Banking and Agricultural Banking to cater the

needs of different sections of the society. Pre-liberalization, PSU banks worked under

government guidance to achieve social objectives. Instead of profit making motto they had social

objectives achievement as their motto. The economic liberalization brought in unprecedented

change in the Indian banking industry, especially for PSU banks. 38

“Competition has been infused into the financial system principally through deregulation

in interest rates. Granting of functional autonomy to banks also brought changes in the outlook of

the PSU banks’ lending operations”. The blurring separation that existed between commercial

banking and investments banking before liberalization has become quite prominent in the post-

liberalization period and swung the pendulum from an era of mass banking to more customized

banking. Leading players like SBI started focusing from mass banking to segmental banking

with rejuvenated energies. 39

The FDI literature has both theoretical and empirical focus and they can be classified into

two broad categories i) Determinants of FDI – No unique and widely accepted theory on

determinates of FDI is available, generally talks about microeconomic and macroeconomic

factors determining the FDI inflows.

Effects of FDI Investment

There are several hypotheses on FDI studies, for instance, differential rate of return,

portfolio investment, output and market size, which assume perfect competition. There are

theories based on n Imperfect markets, which are related to Industrial Organization,

Internationalization, Eclectic Approach and Product Cycle. Other theories such as Agrawal, 1980

and Lizondo, 1991 have studied Liquidity, Currency Area, Trade orientation and anti-trade

oriented FDI (Kojima hypothesis), Political instability, Tax policy, Government regulations etc.

20
All hypotheses have some empirical support but not a single hypothesis has emerged as a leading

one. 40

There three reasons for FDI in India viz, Real Sector Reform, Infrastructural

Development, Privatization. Further he analyzed FDI Growth Phase for India and finds that

1994-1997 is High approval but low FDI Inflows and 1998-2001 is Low approval and high

actual FDI inflows. He argues that the economic reforms of India since the beginning 1990 has

emphasized on attracting more FDI. India’s FDI policies have been liberalized considerably in

nineties resulting to the number of FDI approval and inflows have increased significantly till

1997. After that there was a decline in the FDI approval even though policies have been more

and more liberal. He concludes in his study that, 40% of total FDI was used for Mergers and

Acquisitions and More FDI is needed in Greenfield projects. His findings are Performance of

FDI is companies are better than that of non-FDI companies and however FDI companies’

contribution to exports is not great and their import propensity is quite high.41

The Eclectic Approach is often referred in the literature. The Eclectic approach integrates

three strands of the literature on FDI i.e. the Industrial Organization Theory, The

Internationalization Theory, the Location Theory. If Firm has to engage in FDI then the firm

must have some ownership advantage with respect to other firms, it must be more beneficial for

the firm to use these advantages rather than to sell or lease them to other independent firms and it

must be more profitable to use these advantages in combination with at least some factor inputs

located abroad; otherwise foreign markets would be served exclusively by exports. The Firm

must have ownership and internalization advantage and a foreign country must have locational

advantage over the firm’s home country.42

21
 FDI is simulated by exploitation of proprietary technology or natural resources or by

access to markets. The FDI experience of China and India shows that the willingness of countries

in attracting FDI is one of the major determinants of FDI inflows. Also experience of some

countries shows that along with FDI policies, economic considerations are an imp determinant of

FDI. Economic determinants are broadly classified into three groups i.e. those related to the

availability of location bound resources or assets, those related to the size of markets for goods

and services and those related to cost advantage in production.43

Whether the ownership affected the efficiency of African banks and he argued that in the

last few years, there had been an extensive debate as to whether ownership matters for bank’s

performance in less developed countries. The privately-owned banks outperform state-owned

banks and whether foreign ownership enhances bank performance. Based on a range of

performance ratios as well as parametric and non-parametric estimations, their results showed

that in Africa, on average, privately owned banks do not appear to outperform state-owned

banks. However, where private ownership involves foreign ownership then this does seem to

have a positive effect on bank performance. Because the existing literature focuses heavily on

developed economies, it also puts for than agenda for further study of the causes and effects of

foreign bank entry in developing economies. The past decade has seen a great influx of foreign

banks into developing economies, a trend likely to continue. What benefits is foreign banks entry

likely to bring, and what risks does it pose? Because the literature on this topic relates mainly to

developed economies, it is difficult to fully answer these questions. Many results from studies of

developed economies do not appear to carry over to developing economies. For example, most

such studies have found that domestic banks are more efficient than foreign competitors, which

some researchers have suggested might limit future cross-border consolidation. But the evidence

22
suggests that in developing economies foreign banks typically outperform domestic banks,

indicating a possibility for efficiency-enhancing restructuring through sales of domestic banks to

foreign investors or through cross-border consolidation. Some might argue that the efficiency

benefits for developing economies are self-evident but that foreign entry poses risks for the range

of services provided and the stability of the banking sector. But what evidence there is, provides

only some reassurance. 44

The evidence suggests that foreign banks do more than merely follow their domestic

clients abroad. They appear genuinely interested in pursuing local lending opportunities in

developing economies, even more so than in developed economies. Although they may not

initially enter all sectors equally, the evidence suggests that their entry will be broad enough to

exert competitive pressure on domestic banks, which should benefit consumers through both

prices and services. Although foreign banks could increase instability in developing economies if

they reduce their exposure during financial crises, the evidence from Asia and Latin America

shows that foreign banks have been more likely than domestic banks to extend credit during

recent crisis periods. The crisis in Argentina led some to revisit this issue. Concerns also remain

that foreign entry might expose developing economies to economic fluctuations in the home

countries of foreign banks or in other developing economies where these banks operate. These

contagion effects have not yet been well researched, but having foreign entrants from a

diversified group of countries seems likely to minimize these risks. The initial empirical

evidence on the effect of foreign entry on access to credit by small businesses suggests less

reason for concern than previously thought. Although foreign banks tend to be large and large

banks lend smaller shares of their portfolios to small businesses than do other banks, there are

some signs that technological change might allow large foreign banks to serve this sector.

23
Undoubtedly, this is an area requiring further research. On the question of how the mode of

foreign bank entry affects host countries, the only evidence comes from developed economies.

For mergers and acquisitions, the evidence is mixed. Some studies suggest that because domestic

banks in these countries tend to be more efficient than foreign banks (except for those from the

United States), efficiency gains from mergers and acquisitions are likely to be limited. But other

studies have shown that recent technological changes (like electronic banking) are allowing large

banks such as those that may result from cross-border consolidation to reap benefits from

economies of scale not possible before, perhaps even to the point where they can extend services

to previously neglected customers such as small and medium-size enterprises. According to the

U.S. literature, foreign entry through de novo operations is also likely to benefit small and

medium-size enterprises. Whether the results on mode of foreign entry for developed economies

can be extended to developing economies needs to be empirically tested. Which organizational

form should host countries promote? Recent studies suggest that subsidiaries allow foreign banks

to provide a wider range of activities and could bring greater stability in lending to host countries

than relying on cross-border bank loans. But the empirical evidence is limited, and further

research on this issue is warranted. 45

The services sector’ have discussed Growth of Services sector and its overall impact and

finds that the higher average growth rate of the services sector compared to agriculture and

industry has resulted in an improvement in its share in global GDP. They observed that majority

of the service oriented FDI is directed to finance, transport, telecom, tourism and business

services. Cross-border M & A sales have contributed to the growth in services FDI in Asia with

majority of such cases taking place in North East, South East Asia. Another important feature of

the Asian study has been the increasing efforts towards attracting services FDI through regional

24
integration. The gamut of trade agreement is being widened to comprehensive economic

cooperation agreement (CECA) with liberalization of the services sector being an important

constituent of the later. The ASEAN India (CECA), the Bay of Bengal initiative for more multi-

sectoral, technical and economic cooperation (BIMSTEC) may be cited in this regard with such

initiatives in place and in the offing FDI inflows in services in India could be expected to

increase substantially.46

The survey presented suggests that India is increasingly perceived as a R&D hub for a

wide range of industries. It has become commonplace among foreign investors that India offers a

well educated workforce which, according to Borensztein et al. (1998), is essential for FDI to

have positive growth effects. Likewise, India compares favorably with China in terms of

financial market development (McKinsey Quarterly 2004), which represents another factor

favoring positive growth effects of FDI (Alfaro et al 2001; Choong et al 2004; Hermes and

Lensink 2003) 47

Competitive scenario in Indian Banking in the post reform period has reflected in all

Indian banks including SBI concentrated more on retail banking and shifted from mass banking

to customized banking. The banks changed from its old rigid inflexible system of operations to a

more flexible and practical approach to face the new era. Many new schemes never heard before

in the Indian banking industry came into existence and became profitable and hence the primary

focuses for the banks. Schemes such as Rent-plus, Medi Plus, loans for pensioners, loan against

shares and debentures, loan against mortgage of property, educational loans, housing loans, and

personal loans are major initiatives that were taken up during this period.48

The post liberalization era has seen a sea change also in raising capital. 20 out of 27 PSU

banks have raised capital from the market between 1993 and 2004. These fund and increased

25
NRI funds resulted in a handsome sum for many of these banks. Also reduced CRR limits along

with marginally increased operational profits increased liquidity levels of these banks. On the

other hand there was also reduced demand for the ban k funds from the regular borrowers

including the industrial houses. Increased banks lending rates coupled with availability of

alternative sources of funds, such as the Indian equity markets, global depository receipt, foreign

currency convertible bonds and external commercial borrowings etc., are a few major causes for

this decreased demand. This led to divert to retail lending by banks, which led to repositioning of

the banks through market segmentation by catering to various categories of customers, offering

varied products and services suitable to them. For instance, introduction of special interest rates

for the senior citizens, jewelry loans for women, special banking products for various

professionals like doctors, teachers, and lawyers etc unique savings schemes for children and

offering even loans for marriages come in this category. Recent trends in the personal loans are

an example of designing individualized products. In the personal loans schemes banks are

offering varied interest rates for each individual customer based on his past track record of

repayment, his other commitments, his professional/occupation etc. Many of these services are

also offered through financial brokers/agencies in order to reach wide customer base, leading to

increase customer awareness about the existence and the availability of various products and fill

the gap in customer knowledge levels. Banks also play the role of reference groups.49

Many foreign banks that entered in India, in the post 1991 scenario have feared the

widespread network of the SBI. SBI opened its branches abroad to cater to the international

needs of the foreign customers for India related business. 50

The liberalization opened the gates of the entry of many foreign players in to the country.

All these foreign banks have brought resource both financial and human, along with rich

26
experience to India. They were added to already existing players in India. Leading foreign banks

apart from the new Indian private banks have added fury to the competitive scenario in India and

also geared up their operations within in no time to seize the initial advantage of increased

private participation in the banking industry. Even though in terms of size these foreign banks

have yet not become a major force of reckon with, their approach towards the customers and

their proven experience abroad has become a major force to deal with for Indian Banks. Many of

these banks offer a variety of schemes to suit different category of customer. 51

In pre liberalization, SBI and other Indian PSU banks had restricted themselves to few

product/services. However, post liberalization demands made them to compete with well

diversified and resource rich foreign banks and they fine-tuned their services and offered new

and unique schemes to suit varied customer needs. 52

The existing theoretical works on (Multi National Banks) MNBs have concentrated on

the application of the general theories of FDI, which were developed for manufacturing firms.

The literature suggests that studies concerning MNBs can be compared to FDI in manufacturing

[Aliber 1976; Grubel 1977; Gray and Gray1981]. The regulation of banking, the presence of

MNCs from the home country, cost differentials, and potential reductions in earnings variability

are hypothesized as important factors in determining the presence and growth of MNBs in other

countries. An application of the theory of FDI to MNBs' in LDCs is discussed and a model

incorporating supply and demand factors assessing the determinants of MNBs' expansion into

LDCs is constructed. The reduced form of the model is tested by using pooled data over the

period 1975-1982 for a sample of twenty-three LDCs. His results indicated that the market size,

the presence of multinational corporations from the home country, the extent of economic

27
development, and the balance of payments are all significant determinants of the growth of

MNBs in LDCs.53

The performance of FDI companies using balance sheet data after compilation of over

300 companies by RBI to assess their financial performance is put to understand the performance

of FDI companies with non-FDI companies on their relative efficiency. During 1992-93 to 1999-

2000, sales growth of public limited companies was lower than non-FDI companies in four

years. However, in case of private limited FDI companies, the sales growth was higher in all the

years, except in 1999-2000. The insight derived from the theoretical understandings, empirical

literature and performance of FDI companies in India give mixed picture. It is observed that

Return on Equity, which essentially decides the investment was higher in case of FDI companies

than the non-FDI companies, irrespective of whether they are public limited or private limited

companies. In general performance of FDI companies in terms of sales growth and return on

equity was better than that of non-FDI companies. A comparative analysis of FDI companies

revealed that former is performing well in terms of sales growth, return on equity than later.

However, the trends in export-intensity of sales and import-intensity of exports of FDI

companies are not very encouraging. It implies that FDI companies are concentrating more on

the domestic market for sales and their import requirements are relatively high. 54, 55

1.6 Need for the study

It is found that in the contemporary literature reviewed that it is believed the FDI firms

are better performers that Non-FDI firm in international economics. (P.D. Jeromi, 2002) It is

more than two decades that FDI is introduced in the Indian banking industry as a bundle of

reforms. Therefore, the impact of FDI on productivity, profitability and efficiency of Indian

banking needs to be studied. There is a liberalization of FDI policy from 49% to 74% in 2005,

28
so it become necessary to check if there was an impact of FDI and liberalized FDI policy on the

Indian banking industry.

The present study “Performance Evaluation of Indian FDI and Non-FDI Banks: A

Comparative Analysis”, is undertaken to study the performance of FDI and Non-FDI banks, and

the specific areas of economic performance where FDI has impacted.

Operational Definition for FDI and Non-FDI Banks:

The present study undertakes FDI and Non-FDI Indian Commercial Banks’ performance

evaluation. The FDI definition includes FDI and FII both as FDI to show the impact of Foreign

Investment as an impact of FDI Policy.

FDI Banks are Indian Commercial Banks that have significant level of total foreign

investment FDI and FII. The significant level of FDI taken as more than that of the 50 percent of

total allowed FDI limits in each private sector (37% i.e., fifty percent of 74%) and for each

public sector banks (10% i.e., fifty per cent of 20%). Therefore, for the present study, Public

sector FDI banks are those banks which have more than 10% FDI and are called as FDI banks.

Private sector FDI banks are those banks, which have, more than 37% and are therefore called as

FDI banks.

Non-FDI Banks are the Indian Commercial Banks having non-significant level of total

foreign investment including FDI and FII. Indian Private sector Banks are allowed to have up to

74% of foreign investment according to the Indian FDI Policy.

For Public sector Non- FDI banks are those banks which have less than 10% FDI.

For Private sector Non- FDI banks are those banks which have less than 37%

1.7 Objectives of the Study

1. To study the general impact of liberalized FDI policy on Indian banking industry.

29
 2. To study the productivity of FDI and Non-FDI banks in India post liberalization.

3. To study the profitability of FDI and Non-FDI banks in India post liberalization.

1.8 Hypothesis

1. There is no statistically significant impact of liberalized FDI Policy on the

performance of Indian banking industry.

2. Indian FDI banks have statistically significant productivity performance than the

Indian Non-FDI Banks.

3. Indian FDI banks have statistically significant profitability performance than the

Indian Non-FDI Banks.

1.9 Research Methodology

• The data sources

The study has extensively used secondary sources of data. Data used is yearly data for a

financial year from April 2000-March 2001 to April 2011-March 2012.

Data pertaining to banking sector is collected from Reserve Bank of India’s published

data. Data pertaining to individual bank is collected from Indian Bank’s Association, Mumbai.

Also important data related to foreign investment in individual banks is sought by Right to

Information Act query by the scholar.

• Tools

The Impact of FDI on Indian Banking which is measured using Panel Multiple

Regression Approach using R software.

• The Model Specifications, Data and Description of Variables:

The model used is in testing for the presence of FDI effects on banking sector is

following:

30
 (Performance) it = μ+ α’ D + β’ Xu + V it ------------------------ (1.1)

Here, (performance) it is the performance measure for the ith bank during the tth period.

D is a vector of dummy variable that characterizes FDI.

X it is a vector of other control variables that might affect performance and

V it is a random error term.

α and β the column vectors of the coefficient to be estimated and the elements that

characterize the FDI effects. The specification and model selection is explained in detail in

Chapter 3 – Research Methodology and Tools of Analysis.

Regression analysis helps to measure the impact and relation of the different variables

under study. The available data is a panel data, i.e. a combination of time series and cross

section. Hence Panel Data Multiple Regression is used to see the impact of FDI on entire

banking sector. It includes 49 banks both from public and private sector and six variables sought

after factor analysis. The dummy variable is used to see the policy liberalization impact i.e. by

time dummy putting 2005>= 1 and 2005<=0.

To measure the performance of FDI and Non-FDI banks, FDI content dummy is used.

Accordingly to government of India’s definition (internationally accepted and accepted in India

by P. Chidambaram in his budget speech of Feb 2013) more than 10% of direct or indirect

foreign investment will be called as FDI firm. 56

For public sector 20% FDI is upper limit of FDI ceiling. As already mentioned, the study

takes 50 per cent of that ceiling which is 10% FDI as non-significant FDI and hence dummy is

written as

FDI >10% =1 and FDI <10%=0 for public sector banks.

31
 For Private sector 74% FDI is upper limit of FDI ceiling. So we are taking 50 per cent of

that ceiling which is 37% FDI as non-significant FDI and hence dummy is written as

FDI>37% =1 and FDI<37%=0 for private sector banks.

Total No. of banks under study = 49

Public Sector Banks = 27

Private Sector Banks = 22

There is no single and uniform definition of the performance and efficiency. However, to

measure productivity, the present study is measuring productivity as Profit per Employee (PPE)

and Business per Employee (BPE).

To measure profitability of banks, Net Profit (NP) is taken as a measurement. However,

grossly, Income (Revenue) and Total Business can also be indicative of the performance of the

banks.

1.10 Scope and Limitation of the Study

The scope of the study is limited to the Indian public sector and private sector banks. The

study is limited to yearly data available from 2000-2012 from RBI and IBA, purely secondary

sources of data. The study is hence limited to the time, data availability and reliability of data

and sources. The study is further limited to the analysis of Indian banking industry in the advent

of FDI policy.

Time period of the study

The data requirements of the study are from 1991-2012. The data from 2005 onwards

(FDI data) can be availed from shareholding patterns published in the Appendix of Trends and

Banking published by RBI but data before 2005 is not available with IBA or could not be

reached from RBI. RBI is apex the body in banking and is having data of FDI since 2005-2012

32
on the website. And data from 2000-2001 to 2004-05 was only made available by RBI under

RTI. Data used is yearly data for a financial year from April 2000-March 2001 to April 2011-

March 2012. Thus the study period is from 2000-2001 to 2011-2012.

1.11 Chapter Scheme

The study entitled “Performance Evaluation of Indian FDI and Non-FDI Banks: A

comparative Analysis” is arranged in the following chapters.

• Chapter 1 – Introduction

• Chapter 2 – Review of Literature

• Chapter 3 – Research Methodology and Tools of Analysis

• Chapter 4 – Impact of FDI on Indian Banking Industry

• Chapter 5 – Productivity of FDI and Non-FDI Banks

• Chapter 6 – Profitability of FDI and Non-FDI Banks

• Chapter 7 – Conclusions and Suggestions

1.12 Chapter Summary and Conclusions

The present study introduces to study the impact of FDI Policy on Indian Banking Sector.

The impact is measured by two ways. Firstly, on the banking sector by studying public sector

and private sectors banks together. And second by studying public sector and private sector

banks separately in the light of FDI. The Analysis tries to gauge the impact of FDI liberalization

on the productivity and profitability of FDI and Non-FDI banks in India post liberalization. The

study is organized in seven chapters. First chapter deals with introduction, second chapter gives

literature surveyed, chapter three deals with research methodology. Chapter four, five and six

analyze the impact of FDI on productivity and profitability of banks under study. Chapter seven

gives conclusion and suggestion for the entire study.

33
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